Stocks: Don't Hold Your Breath For More Fed Stimulus

The stock market hemorrhaging continued late last week for a variety of reasons. Included were the deteriorating economic outlook both in the United States and abroad, the mounting threat of crisis in the Euro Zone, and the end of the Fed's Operation Twist looming at the end of June. But although deteriorating economic and market conditions may be raising hopes that a fresh round of Fed stimulus may soon be on its way, investors will likely be forced to wait some time before they receive any further monetary support.

Monetary stimulus programs such as Quantitative Easing (QE) and Operation Twist (OT) are what would be considered extraordinary measures to support the U.S. economy and financial markets. With interest rates already pinned at effectively 0%, Fed policy makers have resorted to these programs as a way to provide additional stimulus in an effort to thwart the full blown collapse of the financial system.

Following the disappointing May jobs report on Friday, some are now speculating that more Fed stimulus is now assured. Some go even further to project that an announcement may come as soon as the upcoming FOMC meeting on June 19-20.

Such an outcome is highly unlikely for the following reasons.

First, the U.S. economy and financial markets are currently far from operating at negative extremes. Here are a few basic points to support this idea.

1.) The U.S. economy ADDED +69,000 jobs in May. Sure the latest report released on Friday was disappointing, but we still ADDED jobs for the month. And since the beginning of 2012, the U.S. economy has ADDED +823,000 net new jobs. To put this into comparative context, the U.S. economy LOST nearly 6 million jobs in the year prior to the launch of QE1 and LOST another 303,000 jobs in the months leading up to the announcement of QE2. The Fed even had what was an initially FLAT reading from the final payroll report from August 2011 (it was later revised higher) prior to launching Operation Twist last year. So while far from strong, it is needless to say that we are operating nowhere near any extreme conditions in employment that would justify rushing out with even more stimulus.

2.) U.S. economic growth as measured by Real GDP INCREASED by 1.9% during the most recently completed quarter according to the latest data release on Thursday. Sure this growth rate was down from the preliminary estimate of 2.2% and represents a deceleration from the 3.0% reading from the prior quarter at the end of 2011, but it still represents an INCREASE. Once again, an economy that is still expanding hardly represents a circumstance where extraordinary measures are required from a monetary policy perspective.

3.) The U.S. stock market as measured by the S&P 500 Index is still HIGHER by +2.6% on a total returns basis. Sure it has corrected by roughly -9% from its recent peak at the beginning of the second quarter, but this represents nothing more than unwinding the robust gains from the first quarter of this year. Once again, the stock market is hardly signaling an emergency when it's still higher than it was only a few months ago.

The fact that investors are even contemplating the idea that the Fed is poised to soon provide more stimuli highlights an even greater dilemma facing policy makers going forward. The problem? The extraordinary has now not only become the ordinary but also the expected.

When the Fed launched QE1 back in early 2009, it was done so with very good reason. The global financial system was teetering on the brink of collapse. Employers were slashing jobs, economic growth was contracting and both stock and bond markets were cascading lower. Even money market accounts were at risk of breaking the buck. Thus, Fed action at the time pulled the global financial system back from the edge, and they should be commended for taking swift and decisive action.

But it was with the announcement of QE2 where the Fed drifted way off track. By March 2010 when QE1 ended, the global economy was no longer on the brink and the financial system had been generally stabilized. Yet only a few months later in August 2010, the Fed felt compelled in to preemptively pour on more stimulus with at the first signs of any renewed weakness. And they effectively did the same by launching Operation Twist in October 2011.

These two later policy actions have created an unhealthy expectation among investors. Extraordinary measures such as QE and Operation Twist are no longer for extreme emergencies. Instead, they are now simply expected, as the belief now firmly exists that the Fed will charge in with more of these special stimulus programs the moment the pace of economic growth ticks lower or the stock market sheds several percent over a few months. The notion of the normal business cycle has been lost in the process. In short, the Fed has set a poor precedent, as they have bound themselves to the capriciousness of the investing public and now face the added dilemma of trying to figure out how to eventually wean investors off of the need for more stimulus while still trying to achieve full employment and price stability. For a violent market reaction to the loss of stimulus or even more the eventual contraction of the Fed's balance sheet would undermine their ability to realize their dual mandate.

So if the Fed is not presently inclined to launch a new stimulus program, what conditions might warrant them to finally relent with another round of QE or Twist down the road? The best reading to monitor in this regard may be the U.S. stock market. The stock market was already in sharp correction by the time the Fed began making suggestions about QE2 and Operation Twist. The peak to trough decline before the serious Fed rumbling began about QE2 was -17%. And the peak to trough sell off prior to the first Fed allusions to what eventually became Operation Twist was -19%. Given that the stock market has only sold off by -9% from recent peaks, this suggests that we have much further to go on the downside before we can reasonably expect the Fed to intervene. Using past precedence, this would imply an S&P 500 trading in the 1140 to 1180 range, which of course is anywhere between -8% to -11% lower than where the market closed on Friday.

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The ongoing risks and the potential for further stock market downside in the weeks and months ahead supports the importance of focusing on categories beyond stocks in the current environment. For while stocks had their worst day of the year on Friday, many other asset class categories posted exceptionally strong performance. This included Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV), which were up +3.9% and 2.4%, respectively, on the first trading day of June. Both precious metals stand to benefit as a safe haven store of value during times of crisis but also an inflation hedge against additional monetary stimulus. Long-Term U.S. Treasuries (NYSEARCA:TLT) also exploded +6.2% higher over the last three trading days of last week, as this area of the market continues to benefit from its safe haven status. The Japanese Yen (NYSEARCA:FXY) also moved higher by +2% over the last four trading days behind the relative safety implied by Japan's status as a highly liquid net investment surplus country. And even more conservative instruments that have shown the ability to perform well regardless of the vagaries of the economy or the stock market also continue to post consistently strong results including Agency MBS (NYSEARCA:MBB), U.S. TIPS (NYSEARCA:TIP), Municipal Bonds (NYSEARCA:MUB) and Build America Bonds (NYSEARCA:BAB). And specifically in the case of Agency MBS , this area of the market is likely to be the key focus of any new Fed stimulus program if and when it arrives.

So despite the hopes of investors, it is likely that the Fed is stuck in a state of economic and market limbo. Conditions have clearly deteriorated, but they have not fallen nearly enough for the Fed to justify additional stimulus at this point. With this being said, the potential still exists that the Fed will act at some point. As a result, also maintaining a small allocation to stocks remains worthwhile to capture any sudden euphoria brought on by the announcement of more stimulus sooner rather than later. A focus on lower beta names such as McDonald's (NYSE:MCD), Tootsie Roll (NYSE:TR) and WGL Holdings (NYSE:WGL) may make sense in this regard.

The major market moving events over the next few weeks in June will likely set the tone for the remainder of the year. Thus, keeping a close eye on markets as events unfold is as worthwhile as ever today.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

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